Adv 1 - 5 - Intercompany Profit Transactions - Inventories #2

Chapter 5
Intercompany
Profit
Transactions –
Inventories
Intercompany Profits – Inventories:
Objectives
1. Understand the impact of intercompany profit
in inventories on preparing consolidation
workpapers.
2. Apply the concepts of upstream versus
downstream inventory transfers.
3. Defer unrealized inventory profits remaining in
the ending inventory.
4. Recognize realized, previously deferred,
inventory profits in the beginning inventory.
© Pearson Education Limited 2015 5-2

Objectives (cont.)
5. Adjust noncontrolling interest amounts in the

presence of intercompany inventory profits.

Workpaper Entries
1. Adjust for errors & omissions

2. Eliminate intercompany profits and losses
3. Eliminate income & dividends from sub. and
bring Investment account to its beginning
balance
4. Record noncontrolling interest in sub.'s
earnings & dividends
5. Eliminate reciprocal Investment & sub.'s
equity balances
6. Amortize fair value differentials
7. Eliminate other reciprocal balances

Intercompany Profit Transactions – Inventories
1: INTERCOMPANY
INVENTORY PROFITS

Intercompany Transactions
For consolidated financial statements

– “intercompany balances and transactions shall be
eliminated.” [FASB ASC 810-10-45-1]
Show income and financial position as if the
intercompany transactions had never taken
place.

Intercompany Sales of Inventory
Profits on intercompany sales of inventory

– Recognized if goods have been resold to
outsiders
– Deferred if the goods are still held in inventory
Previously deferred profits in beginning
inventory are recognized in the period the
goods are sold. Assuming FIFO
– Beginning inventories are sold
– Ending inventories are from current purchases

Elimination of Intercompany
Purchases and Sales
Example :
Pin Corporation formed a subsidiary, Sep Corporation,
in 2011 to retail a special line of Pin’s merchandise.
All Sep’s purchases are made from Pin Corporation at
20% above Pin’s cost. During 2011, Pin sold
merchandise that cost $40,000 to Sep for $48,000,
and Sep sold all the merchandise to its customers for
$60,000. Both Pin and Sep record journal entries
relating to the merchandise on their separate books,
as follows:

PIN’S BOOKS
Inventory (+A) 40,000

Accounts payable (+L) 40,000
To record purchases on account from other entities.
Accounts receivable—Sep (+A) 48,000

Sales (R, +SE) 48,000
To record intercompany sales to Sep.
Cost of sales (E, -SE) 40,000

Inventory (-A) 40,000
To record cost of sales to Sep.

SEP’S BOOKS

To record intercompany purchases from Pin.

Sales (R, +SE) 60,000
To record sales to customers outside the consolidated
entity.

To record cost of sales to customers.

We eliminate that overstatement in the consolidation
workpapers, where measurements for consolidated
sales and cost of sales are finalized. The workpaper
elimination is as follows:
100% Sep Adjustments and

Pin Consolidated
Eliminations
Sales $48,000 $60,000 48,000a $60,000
Cost of Sales 40,000 48,000 48,000a 40,000
Gross profit 8,000 12,000 20,000

Elimination of Unrealized Profit in
Ending Inventory
Example :
During 2012 Pin sold merchandise that cost $60,000
to Sep for $72,000, and Sep sold all but $12,000 of
this merchandise to its customers for $75,000.
Journal entries relating to the merchandise
transferred intercompany during 2012 are as follows:

PIN’S BOOKS


Sales (R, +SE) 72,000


SEP’S BOOKS


Sales (R, +SE) 75,000
To record sales to customers outside the consolidated entity.

To record cost of sales to customers.

The eliminations follows:

Pin Consolidated
Eliminations
Income statement
Sales $72,000 $75,000 72,000a $75,000
Cost of Sales 60,000 60,000 2,000b 72,000a 50,000
Gross profit 12,000 15,000 25,000
Balance Sheet
Inventory 12,000 2,000b 10,000

Recognition of Unrealized Profit in
Beginning Inventory
Example :
During 2013, Pin Corporation sold merchandise that
cost $80,000 to Sep for $96,000, and Sep sold 75%
of the merchandise for $90,000. Sep also sold the
items in the beginning inventory with a transfer price
of $12,000 to its customers for $15,000. Journal
entries relating to the merchandise transferred
intercompany follow:

PIN’S BOOKS


Sales (R, +SE) 96,000


SEP’S BOOKS


Sales (R, +SE) 105,000
To record sales to customers outside the consolidated entity. (90,000+15,000)

To record cost of sales to customers. ((96,000*75%)+12,000)

The eliminations follows:

Pin Consolidated
Eliminations
Income statement
Sales $96,000 $105,000 96,000a $105,000
96,000a
Cost of Sales
80,000 84,000 4,000c 2,000b 50,000
Gross profit 16,000 21,000 25,000
Balance Sheet
Inventory xxx 24,000 4,000c 20,000
Investment in Sep xxx 2,000b

Next
Session
Intercompany Profit Transactions – Inventories
2: UPSTREAM &
DOWNSTREAM INVENTORY
SALES

Upstream and Downstream Sales
Downstream
Sales
Parent
Parent sells to Subsidiary sells

subsidiary to parent
Subsidiary 1 Subsidiary 2 Subsidiary 3
Upstream Sales

Downstream and Upstream Effects
on Income Computations
Assume that the separate incomes of a parent and its 80%-
owned subsidiary for 2011 are as follows (in thousands):
Parent Subsidiary
Sales $600 $300
Cost of Sales 300 180
Gross profit 300 120
Expenses 100 70
Parent’s separate income $200
Subsidiary’s net income $50
Intercompany sales during the year are $100,000, and the

December 31, 2011, inventory includes $20,000 unrealized
profit.

PARENT CORPORATION AND SUBSIDIARY CONSOLIDATED INCOME
STATEMENT (IN THOUSAND) FOR THE YEAR ENDED DEC 31, 2011
Donwstream Upstream
Sales Sales
Sales $800 $800
Cost of Sales 400 400
Gross profit 400 400
Expenses 170 170
Consolidated net income 230 230
Less: Noncontrolling interest share 10 6
Controlling interest share of consolidated
$220 $224
net income

• If the intercompany sales are downstream, the parent’s sales
and cost of sales accounts reflect the $20,000 unrealized profit,
and the subsidiary’s $50,000 net income is equal to its realized
income. In this case the noncontrolling interest share
computation is unaffected by the intercompany transactions
and is computed as
$50,000 net income of subsidiary * 20% = $10,000
• If the intercompany sales are upstream, the subsidiary’s sales

and cost of sales accounts reflect the $20,000 unrealized profit,
and the subsidiary’s realized income is $30,000. In this case the
noncontrolling interest share computation is
($50,000 net income of subsidiary - $20,000 unrealized) * 20% = $6,000

Downstream

CONSOLIDATION EXAMPLE—INTERCOMPANY
PROFITS FROM DOWNSTREAM SALES
Say Corporation is a 90%-owned subsidiary of Pak Corporation,

acquired for $94,500 cash on July 1, 2011, when Say’s net assets
consisted of $100,000 capital stock and $5,000 retained earnings. The
cost of Pak’s 90% interest in Say was equal to book value and fair value
of the interest acquired ($105,000 × 90%), and accordingly, no
allocation to identifiable and unidentifiable assets was necessary.
Pak sells inventory items to Say on a regular basis, and the

intercompany transaction data for 2014 are as follows:
Sales to Say in 2014 (cost $15,000), selling price $20,000

Unrealized profit in Say’s inventory at December 31, 2013
2,000
(inventory was sold during 2014)
Unrealized profit in Say’s inventory at December 31, 2014 2,500
Say’s accounts payable to Pak at December 31, 2014 10,000

Equity Method
At Dec 31, 2013, Pak’s Investment in Say account had a balance of
$128,500. This balance consisted of Pak’s 90 percent equity in Say’s
$145,000 net assets on that date less $2,000 unrealized profit in Say’s
December 31, 2013, inventory.
During 2014, Pak made the following entries on its books for its
investment in Say under the equity method:
Cash (+A) 9,000

Investment in Say (-A) 9,000
To record dividends from Say ($10,000 * 90%).
Investment in Say (+A) 26,500

Income from Say (R, +SE) 26,500
To record income from Say for 2014 computed as follows:
Equity in Say’s net income ($30,000 * 90%) $27,000

Add: 2013 inventory profit recognized in 2014 2,000
Less: 2014 inventory profit deferred at year-end (2,500)
26,500

Year ended 31 Dec 2014 Pak Say Pak Say
Income statement: Balance Sheet, 31 Dec 2014
Net sales 1,000 300 Cash 30 5
Income from Say 26.5 - Accounts receivable 70 20
Cost of goods sold (550) (200) Inventory 90 45
Other current assets 64 10
Other expenses (350) (70)
Plant and equipment 800 120
Controlling share of net 126.5 30
income Investment in Say 146 -
Total 1200 200
Statement of retained
earnings:
Retained earnings—Pak 194 - Accounts payable 80 15
Retained earnings—Say - 45 Other liabilities 49.5 20
Capital stock 800 100
Controlling share of net income 126.5 30
Retained earnings 270.5 65
Dividends (50) (10)
Total 1200 200
Retained earnings—Dec 31 270.5 65

Journal Entries

• none
Sales (− R , − SE ) 20,000
Cost of goods sold (− E, + SE ) 20,000
To eliminate intercompany sales
Investment in Say (+ A ) 2,000

To adjust unrealized profits in the beginning inventory.

Inventory (− A ) 2,500
To eliminate unrealized profits in the ending inventory

Journal Entries
3. Eliminate income & dividends from sub.

Income from Say (− R , − SE ) 26,500
Dividends (+ SE ) 9,000
Investment in Say (− A ) 17,500
To eliminate the investment income and 90% of the dividends of Say

Noncontrolling interest share ( − SE ) 3,000
Noncontrolling interest (+ SE ) 2,000
To enter noncontrolling interest share of subsidiary income and dividends.

Journal Entries

equity balances
Capital stock—Say (− SE ) 100,000
Retained earnings—Say (− SE ) 45,000
Investment in Say (− A ) 130,500
To eliminate reciprocal account

• none
Accounts payable (− L ) 10,000
Accounts receivable (− A ) 10,000
To eliminate reciprocal payables and receivables from intercompany sales.

Pak's 2014 Worksheet
Year ended 31 Dec 2014 Pak Say DR CR Consol
Income statement:
Net sales 1,000 300 20a 1,280
Income from Say 26.5 - 26.5d -
Cost of goods sold (550) (200) 2.5c 20a (730.5)
2b
Other expenses (350) (70) (420)
Consolidated net income 129.5
Noncontrolling interest share 3e (3)
Controlling share of net income 126.5 30 126.5
Statement of retained earnings:

Retained earnings—Pak 194 -
Retained earnings—Say - 45 45f
Controlling share of net income 126.5 30
9d
Dividends (50) (10) (50)
1e
Retained earnings—December 31 270.5 65 270.5

Balance Sheet, 31 Dec 2014 Pak Say DR CR Consol
Cash 30 5 35
Accounts receivable 70 20 10g 80
Inventory 90 45 2.5c 132.5
Other current assets 64 10 74
Plant and equipment 800 120 920
Investment in Say 146 - 2b 17.5df -
130.5
Total 1200 200 1,241.5
Accounts payable 80 15 10g 85

Other liabilities 49.5 20 69.5
Capital stock 800 100 100f 800
Retained earnings 270.5 65 270.5
Noncontrolling interest, Jan.1 14.5f 16.5
Noncontrolling interest, Dec. 31 2e
Total 1200 200 1,241.5

Exercise

P 5-8 Consolidated workpapers
(downstream sales)
Pan Corporation acquired 100% of Sal Corporation’s outstanding
voting common stock on January 1, 2011, for $660,000 cash. Sal’s
stockholders’ equity on this date consisted of $300,000 capital stock
and $300,000 retained earnings. The difference between the price paid
by Pan and the underlying equity acquired in Sal was allocated $30,000
to Sal’s undervalued inventory and the remainder to goodwill. The
undervalued inventory items were sold by Sal during 2011.
Pan made sales of $100,000 to Sal at a gross profit of $40,000

during 2011; during 2012, Pan made sales of $120,000 to Sal at a gross
profit of $48,000. One-half the 2011 sales were inventoried by Sal at
year-end 2011, and one-fourth the 2012 sales were inventoried by Sal
at year-end 2012. Sal owed Pan $17,000 on account at December 31,
2012.

P 5-8 Consolidated workpapers
(downstream sales)
The separate financial statements of Pan and Sal Corporations at
and for the year ended December 31, 2012, are summarized as follows
(in thousands):
Pan Sal
Combined Income and Retained Earnings Statements for the Year
Ended December 31, 2012 (in thousands)
Sales $ 800 400
Income from Sal 108 -
Cost of sales (400) (200)
Depreciation expense (110) (40)
Net income 206 100
Beginning retained earnings 606 380
Less: Dividends (100) (50)
Retained earnings December 31, 2012 712 430

Pan Sal
Balance Sheet at December 31, 2012
Cash 54 37
Receivables—net 90 60
Inventories 100 80
Other assets 70 90
Land 50 50
Buildings—net 200 150
Equipment—net 500 400
Investment in Sal 748 -
Total assets 1,812 867
Accounts payable 160 47
Other liabilities 340 90
Common stock, $10 par 600 300
Retained earnings 712 430
Total equities 1,812 867
REQUIRED:
Prepare workpapers to consolidate the financial statements of Pan Corporation
and Subsidiary at and for the year ended Dec 31, 2012.

Upstream

CONSOLIDATION EXAMPLE—INTERCOMPANY
PROFITS FROM UPSTREAM SALES
Sit Corporation is an 80%-owned subsidiary of Poh Corporation,

acquired for $480,000 on January 2, 2011, when Sit’s stockholders’
equity consisted of $500,000 capital stock and $100,000 retained
earnings. The investment cost was equal to the book value and fair
value of Sit’s net assets acquired, so no fair value/book value
differential resulted from the acquisition.
Sit Corporation sells inventory items to Poh Corporation on a regular

basis. The intercompany transaction data for 2012 are as follows:
Sales to Poh in 2012 $300,000

Unrealized profit in Poh’s inventory, December 31, 2011
40,000
(inventory was sold during 2012)
Unrealized profit in Poh’s inventory, December 31, 2012 30,000
Intercompany accounts receivable and payable at Dec 31,
50,000
2012

Equity Method
At December 31, 2011, Poh’s Investment in Sit account had a balance
of $568,000, consisting of $600,000 underlying equity in Sit’s net assets
($750,000 × 80%) less 80 percent of the $40,000 unrealized profit in
Poh’s December 31, 2011, inventory from upstream sales.
During 2012, Poh made the following entries to account for its
investment in Sit under the equity method:
Cash (+A) 40,000

Investment in Sit (-A) 40,000
To record dividends from Sit ($50,000 * 80%).
Investment in Sit (+A) 88,000

Income from Sit (R, +SE) 88,000
To record income from Sit for 2012 computed as follows:
Equity in Sit’s net income ($100,000 * 80%) $80,000

Add: 80% of $40,000 unrealized profit deferred in 2011 32,000
Less: 80% of $30,000 unrealized profit at December 31, 2012 (24,000)
88,000

Year ended 31 Dec 2012 Poh Sit Poh Sit
Income statement: Balance Sheet
Net sales 3,000 1,500 Cash 200 50
Income from Sit 88 - Accounts receivable 700 100
Inventory 1,100 200
Cost of goods sold (2,000) (1,000)
Plant and equipment 2,000 500
Controlling share of net 500 100
income Investment in Sit 616 -
Total 5,000 1,000
Retained earnings—Poh 1,000 - Accounts payable 500 150
Retained earnings—Sit - 250 Other liabilities 400 50
Controlling share of net income 500 100 Capital stock 3,000 500
Dividends (400) (50) Retained earnings 1,100 300
Retained earnings—Dec 31 1,100 300 Total 5,000 1,000

Journal Entries

• none
Sales (− R , − SE ) 300,000
To eliminate intercompany sales
Investment in Sit (+ A ) 32,000

Noncontrolling interest (− SE ) 8,000
To adjust unrealized profits in the beginning inventory.

Inventory (− A ) 30,000
To eliminate unrealized profits in the ending inventory

Journal Entries
3. Eliminate income & dividends from sub.

Income from Sit (− R , − SE ) 88,000
Investment in Sit (− A ) 48,000
To eliminate the investment income and 80% of the dividends of Sit

Noncontrolling interest share ( − SE ) 22,000
To enter noncontrolling interest share of subsidiary income and dividends.

Journal Entries

equity balances
Capital stock—Sit (− SE ) 500,000
Retained earnings—Sit (− SE ) 250,000
Investment in Sit (− A ) 600,000
To eliminate reciprocal account

• none
Accounts payable (− L ) 50,000
Accounts receivable (− A ) 50,000
To eliminate reciprocal payables and receivables from intercompany sales.

Poh's 2012 Worksheet
Year ended 31 Dec 2012 Poh Sit DR CR Consol
Income statement:
Net sales 3,000 1,500 300a 4,200
Income from Sit 88 - 88d -
Cost of goods sold (2,000) (1,000) 30c 300a 2,690
40b
Other expenses (588) (400) 988
Consolidated net income 522
Noncontrolling interest share 22e (22)
Controlling share of net income 500 100 500

Retained earnings—Poh 1,000 - 1,000
Retained earnings—Sit - 250 250f -
Controlling share of net income 500 100 500
Dividends (400) (50) 40d (400)
10e
Retained earnings—December 31 1,100 300 1,100

Balance Sheet, 31 Dec 2012 Poh Sit DR CR Consol
Cash 200 50 250
Accounts receivable 700 100 50g 750
Inventory 1,100 200 30c 1,270
Other current assets 384 150 534
Plant and equipment 2,000 500 2,500
Investment in Sit 616 - 32b 48df -
600
Total 5,000 1,000 5,304
Accounts payable 500 150 50g 600

Other liabilities 400 50 450
Capital stock 3,000 500 500f 3,000
Retained earnings 1,100 300 1,100
Noncontrolling interest, Jan.1 8b 150f
Noncontrolling interest, Dec. 31 12e 154
Total 5,000 1,000 5,304

Exercise

P 5-7 Consolidation workpapers
(upstream sales, noncontrolling interest)
Pol Corporation purchased a 90% interest in San Corporation on

Dec 31, 2010, for $2,700,000 cash, when San had capital stock of
$2,000,000 and retained earnings of $500,000. All San’s assets and
liabilities were recorded at their fair values when Pol acquired its
interest. The excess of fair value over book value is due to previously
unrecorded patents and is being amortized over a 10-year period.
The Pol–San affiliation is a vertically integrated merchandising
operation, with San selling all of its output to Pol Corporation at 140
percent of its cost. Pol sells the merchandise acquired from San at 150
percent of its purchase price from San. All of Pol’s December 31, 2011,
and December 31, 2012, inventories of $280,000 and $420,000,
respectively, were acquired from San. San’s December 31, 2011, and
December 31, 2012, inventories were $800,000 each.

P 5-7 Consolidation workpapers
(upstream sales, noncontrolling interest)
Pol’s accounts payable at December 31, 2012, includes $100,000
owed to San from 2012 purchases. Comparative financial statements for
Pol Corporation and San Corporation at and for the year ended
December 31, 2012, are as follows (in thousands):
Pol Sal
Combined Income and Retained Earnings Statement for the Year
Ended December 31, 2012
Sales $ 8,190 5,600
Income from San 819 -
Cost of sales (5,460) (4,000)
Other expenses (1,544) (600)
Net income 2,005 1,000
Add: Beginning retained earnings 1,200 700
Deduct: Dividends (1,000) (500)
Retained earnings December 31, 2012 2,205 1,200

Pol San
Balance Sheet at December 31, 2012
Cash 753 500
Inventory 420 800
Plant assets—net 3,000 3,000
Investment in San 3,132 -
Total assets 7,905 4,500
Current liabilities 1,700 1,300
Common stock 4,000 2,000
Retained earnings 2,205 1,200
Total equities 7,905 4,500
REQUIRED:
Prepare consolidation workpapers for Pol Corporation and Subsidiary for the year
ended December 31, 2012.

Thank You

Adv 1 - 5 - Intercompany Profit Transactions - Inventories #2

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Chapter 5

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5. Adjust noncontrolling interest amounts in the

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1. Adjust for errors & omissions

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For consolidated financial statements

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Profits on intercompany sales of inventory

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Inventory (+A) 40,000

Accounts receivable—Sep (+A) 48,000

Cost of sales (E, -SE) 40,000

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Inventory (+A) 48,000

Accounts receivable—Sep (+A) 60,000

Cost of sales (E, -SE) 48,000

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100% Sep Adjustments and

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Inventory (+A) 60,000

Accounts receivable—Sep (+A) 72,000

Cost of sales (E, -SE) 60,000

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Inventory (+A) 72,000

Accounts receivable—Sep (+A) 75,000

Cost of sales (E, -SE) 60,000

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100% Sep Adjustments and

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Inventory (+A) 80,000

Accounts receivable—Sep (+A) 96,000

Cost of sales (E, -SE) 80,000

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Inventory (+A) 96,000

Accounts receivable—Sep (+A) 105,000

Cost of sales (E, -SE) 84,000

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100% Sep Adjustments and

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Parent sells to Subsidiary sells

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Intercompany sales during the year are $100,000, and the

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• If the intercompany sales are upstream, the subsidiary’s sales

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Say Corporation is a 90%-owned subsidiary of Pak Corporation,

Pak sells inventory items to Say on a regular basis, and the

Sales to Say in 2014 (cost $15,000), selling price $20,000

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Cash (+A) 9,000

Investment in Say (+A) 26,500

Equity in Say’s net income ($30,000 * 90%) $27,000

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1. Adjust for errors & omissions